Estonia has much to teach us about how real austerity works in practice

Dr Piotr Konwicki is principal finance lecturer at BPP Business School, and a former senior investment banker at Lazard Freres and Deutsche Bank.

Dr Piotr Konwicki

WITH the Budget fast approaching, David Cameron announced last week that his government will stick to its course, with its policy of austerity. It’s the dividing line in British politics today – whether or not austerity is working effectively.

But step back for a moment – define austerity and ask whether the government is implementing it. As a non-native speaker, I referred to the Oxford English Dictionary, which has the following definition: difficult economic conditions created by measures to reduce expenditure. While we can agree that conditions are difficult, has the government reduced expenditure? Public spending as a percentage of GDP increased from 34.6 per cent in 2000-01 to 46.7 per cent in 2010-11. According to the Office for Budget Responsibility, it will only fall to 43.1 per cent in 2012-13. But spending will rise from £643.8bn in 2011-12 to £660.7bn in 2012-13.

The economy has stagnated. But the coalition’s “policy of austerity” has not resulted in a large decrease in public spending. Is there no alternative?

Consider Estonia, a small, post-Soviet Baltic republic, which embarked on a much more literal austerity policy to Britain. In August 2012, a difference of opinion over its performance led to a Twitter battle between Paul Krugman and the Estonian President Toomas Hendrik Ilves. According to Krugman, this “poster child for austerity defenders” was no economic triumph.

But look at the facts. After re-gaining independence from the Soviet Union 20 years ago, Estonia embarked on a radical transformation into an open, trading economy. It forged close ties with neighbours, and entered the digital age with gusto (in 2012, over 92 per cent of income tax returns were submitted via the internet and 90 per cent of parking fees were paid using mobile phones). It also created favourable conditions for entrepreneurs – its capital Tallinn is home to Skype, and in 1994 Estonia was a pioneer in introducing a flat tax rate of 26 per cent for companies and individuals.

Estonia boasts unusually thrifty politicians and an open public culture. It scores well in business-friendliness. And these policies brought about spectacular growth: between 2000 and 2007, GDP climbed by an average of 8.2 per cent per year. Yet the 2008 crisis affected Estonia badly – in 2008-2009, its economy shrank by nearly 20 per cent.

The government responded in a different way to the rest of Europe – by implementing austerity measures, Estonian-style. Public sector salaries were cut by 10 per cent. The exception was cabinet members, who saw their pay fall by 20 per cent. And the government was smart about further cuts. Departmental spending was trimmed by 7 and then 8 per cent in two waves in 2009 – but payments to pensioners went up by 5 per cent. An increase in the pension age was planned (from 63 for men and 60.5 for women) to a universal 65 years, and it was made harder to claim health benefits. Further, the government adhered to its original tax reduction schedule, and in 2008 personal and corporate taxes were reduced to 21 per cent.

These policies initially resulted in sharp contraction. In 2009, GDP tumbled by 14 per cent. Unemployment hit 19 per cent and wages fell dramatically – in some cases by as much as 40 per cent. But more important is how the economy reacted later. In 2010, GDP increased by 3.3 per cent, by 8.28 per cent in 2011 and by 3 per cent in 2012. Despite the 2008 crisis and problems in the Eurozone, over the last decade the country grew by an average of 3.4 per cent a year. As a result, public finances improved: the country ran a budget deficit of 2.9 per cent of GDP in 2008, but by 2010 it had a surplus of 0.2 per cent, increasing to 1.1 per cent in 2011. Public debt, at 6.6 per cent of GDP, is by far the lowest in the EU.

This is a real case of austerity. But does it mean that Cameron should copy Estonian solutions? Estonia is, of course, different to the UK. It is both much smaller and far more open (trade constitutes about 150 per cent of Estonian GDP, compared to 60 per cent in Britain). Estonia is also a large net recipient of EU structural funds – almost 20 per cent of its 2012 budget. But we should watch this small Baltic nation with interest: proper austerity, with cleverly-designed cuts, while protecting the most vulnerable, does not have to ruin a country – just the opposite. And it can be politically popular. Cameron might note that, in March 2011, Estonians re-elected its pro-austerity parties without complaint.

Dr Piotr Konwicki is principal finance lecturer at BPP Business School, and a former senior investment banker at Lazard Freres and Deutsche Bank.